As with anything in life, nothing stands on its own. In economics and investing, there are many links between different strategies and markets. Two such essential terms to note are inflation and interest rates. These two things may appear as separate entities at first, but they very closely impact each other.
Before we can dive into how inflation and interest rates affect one another, we should look a little closer at what they are and how they differ.
What Is Inflation?
Inflation is the rate at which services and goods increase in price. A house 20 years ago is worth far more now, and this is due to inflation.
What Are Interest Rates?
When you borrow money, the lender charges a percentage of the total amount borrowed. This interest has to be repaid on top of the borrowed capital. These rates fluctuate over time for a variety of reasons. A significant factor behind rising and lowering interest rates is inflation.
How do they impact each other?
Inflation is a natural given in life. Over time, the value of most things increases, and with it, wages must increase. If a lender never charged interest on a loan, they would end up losing value in the long run due to inflation.
Think of it this way. Let’s say you borrowed $5000 from someone back in the year 2000. You finish paying it off in 2020. They still have the $5000 as they decided not to charge you interest. Is it a win-win? They have their money back, and you never had to pay interest, right? Wrong. An amount of $5000 in 2000 would be valued at closer to $7634 in 2020 thanks to inflation. By not charging interest, they missed out on $2634.
As inflation rises, interest rates can increase in an attempt to recoup this loss. However, the relationship between inflation and interest rates is far more complex, and they usually tip back and forth rather than grow steadily together.
If there’s a significant economic issue, banks and governments will often lower interest rates to stimulate the economy. We saw this in how interest rates behaved during 2020 and the COVID-19 pandemic in Canada as the government attempted to avoid a housing market crisis.
Generally speaking, when interest rates are low, the economy is stimulated, and we see growth in inflation. On the other hand, when interest rates are too high, there’s a decrease in spending and a plateau in inflation. Interest rates and inflation often act as the two ends of a scale. There’s a delicate balance between the two to keep the economy stimulated and growing without lowering interest rates too much and negatively impacting inflation and growth.
The relationship between inflation and interest rates is important to remember when investing. To invest without considering this relationship could lead to unnecessary losses. Inflation can impact the interest rates of any investment, regardless of its market, depending on various factors. To learn more about these factors and how they may impact mortgage investments, contact Jordan on our team.